One of the reasons I decided to start writing a blog was to increase the clarity of my own thought process. As such, this week I wanted to give some deep thought to the categories of investment situations that I have historically invested in, and continue to look for. I’m a firm believer in Einstein’s saying that “if you can’t explain it simply, you don’t understand it well enough,” and I’m hoping that a positive externality to come from writing a blog is that I will expose any gaping deficiencies in my own knowledge.
The overarching situation I’m looking for is a mispricing. Whether that’s a mispricing of growth, confusing risk with uncertainty or a degree of complexity that obscures the opportunity, I’m agnostic.
After going through my historical investments, I found that I could classify the type of situations into four buckets:
- Hide & Seek
- Free call options
- Short-term pain, for long-term gain
- Special situations
The first bucket of investment ideas, Hide & Seek, are situations where the underlying quality or earnings power of the asset is not observable through simply looking at the financial statements the company releases. In other words, they are hidden. To find these situations you have to turn over a lot of rocks and be willing to think about the business not in terms of what it is currently earning, but by what it could be. These ideas are hard to come by and you have to seek them out.
Within this bucket, I break it down further into hidden value & hidden quality. Stocks with hidden value properties are usually good businesses that, for some reasons or another, are going through a period of “under-earning.” Essentially, what I mean by this is that there are some short term (and they must be transitory) issues that are causing the current level of profitability (operating margins etc.) to be significantly lower than one might expect it to be in “normal” times.
A perfect example of this type of situation is an investment I posted on SumZero in June 2016. The company, Redhill Education, made the decision to double its footprint by replicating its current Sydney campus, in Melbourne. This process was going to take around 18 months and was expected to materially impact the profitability of the business for two financial years. These costs, as well as the potential opportunity, were all explained to the market well in advance, yet the share price fell from $1.50 to around $0.80. As alluded, the company printed an FY16 result that showed strong top-line growth but a large all in margins from ~13% to ~5%. What’s important here is that the Sydney campus remained highly profitable and continued to grow throughout this process. At $0.80 the Sydney campus was trading on a free cash flow yield of >15% but its profitability was being masked in the short term by the expansionary investments in the Melbourne campus. This was a perfect hidden value opportunity.
The second sub-sector of the hide & seek bucket is hidden quality. For this type of investment, the underlying quality of the assets in a business becomes obscured by some factor. A few examples include:
- Accounting treatment
- Being combined with a lower quality business
- Current management team or structure being unable to “monetise” the assets
A European example of a quality assets being disguised by different factors was El.EN S.p.A. Due to the accounting treatment for equity investments where the control is above a certain threshold, EL.EN was required to consolidate the performance of a former US subsidiary onto its balance sheet and P&L. This had a twofold impact of making the ROE look poor due to the lower profitability of the US firm and as well as masking the underlying performance of the core business, which was showing signs of improvement and strong growth
The second bucket of investment situations free call options essentially stems from my tendency to ask “what if.” Markets hate uncertainty and often overly discount it. This can allow for the purchase of a business at a fair price, but with a free option attached. A free option exists when a company’s future includes a broad range of outcomes, stemming from new potential contract wins, acquisitions, discoveries, take-up rates for new offerings etc. The key is to find stocks where these potential new growth drivers are not factored into the current share price and then ask, “well what would the business be worth if this happened?” Monhish Pabrai refers to this type of investment as “heads I win, tails I don’t lose much,” meaning that, the business is currently a fair price for the current operations, but if “this or that” happens, it is likely to be worth multiples of the current price.
These opportunities often occur in former market darling businesses that hit a rough patch, companies with a large net cash balance sheet and “roll up” or acquisition led growth stories. The ideal opportunity here would arise when a firm with a history of making value accretive acquisitions, is trading at a price that only reflects the organic growth prospects of the existing business. Here the thought process would be “well they have $Xm in the bank and could probably borrow $Ym, so what if they deployed that capital into acquisitions at a multiple of Z?” The ability for the firm to materially alternate the growth trajectory of the group represents a call option. The idea is to find the opportunities where you get them for free.
A good example of this type of situation is the British firm Keywords Studios. Its business model is to consolidate the fragmented outsourced video game design industry. When we first came across Keywords, the stock was trading at a level that implied earnings growth of 10-15% p.a. for 5-10 years. After discussions with the management team and people within the video game industry, we came to the conclusion that overall industry growth, combined with the trend towards outsourcing, should allow Keywords to grow organically by 15% per annum into the foreseeable future. However, a key part of its growth strategy is to acquire sub-scale operators, integrate them into a larger operation and generate substantial synergies. The company had surplus cash on the balance sheet and banks willing to provide substantial financing at attractive rates. We considered a range of potential scenarios in which Keywords deployed this capital at different acquisition multiples and calculated the expected impact on profitability and the valuation of the firm. After establishing that the upside potential was indeed large, we decided to take a position given the downside was limited as the business was currently fairly valued, but the upside if they continued to make acquisitions was very attractive. Heads I win big, tails I shouldn’t lose too much.
The third category of investment situations that I consider arise when a high-quality compounder hits a bit of a rough patch. These investments are very similar to the hide & seek category, except the quality and value of the business is not obscured. These opportunities arise because investors are unwilling to sit through short periods of poor business performance or volatility, despite the prospect of substantial long term returns – in modern markets, if a stock has negative earnings revisions for 12 months forward, it is heading lower. Investors are unwilling to sit through short term pain despite potentially very attractive long-term prospects.
The important consideration with these investments is whether the current headwinds are short term, cyclical or secular. If a high quality compounder is trading cheaply due to secular headwinds, the business is unlikely to ever return to its former glory and will probably be in terminal decline. What you want to find are issues that are likely to persist for a short period but not cause permanent damage to the competitive position of the firm. Markets will shoot first and ask questions later. This allows the patient investor with no liquidity demands to acquire positions at very attractive prices.
It is worth noting that the “investment buckets” are not mutually exclusive and often an investment idea will fall into multiple categories. For example, I may initially be attracted to an idea because it has some untapped earning power that should be leveraged in the coming years. This would be classified as a hide & seek investment. However, before the earning power can be leveraged, the business may be re-investing in growth for the next year or two, leading to lower earnings year-on-year. Now the investment has attributes of the short-term pain, for long-term gain bucket because the share price is highly likely to continue falling before the market can begin to appreciate the underlying value.